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Planning Ahead: Sinking Funds

Not all expenses are paid monthly. Some come quarterly, semi-annually, or annually. Some don't have any particular schedule to them at all, but are out there somewhere beyond the horizon waiting to bite you on the posterior when you least expect them and/or least have the resources to handle them.

A successful financial plan should include a sub-plan for handling these irregular expenses. NOT having a plan to handle them is bound to lead to having other parts of the financial plan knocked off the rails. Sinking funds are an effective way to put back money for those non-monthly expenses, both expected and unexpected.

What is a sinking fund and how does it differ from an emergency fund? The distinction has to do with whether an expense is expected or unexpected. The purpose of a sinking fund is to put away or “sink” a certain amount of money on a regular basis in order to have the funds available to pay an expected expense once it comes due. The purpose of an emergency fund is to cover unexpected expenses.

If an expense is certain to occur at a specific point in time on a recurring non-monthly schedule, such as property taxes or insurance premiums, then a sinking fund should be set up for it. If an expense is unplanned, then it should be paid from the emergency fund. Between those two ends of the spectrum are a number of expenses which are not wholly one type or the other.

How those in-between expenses are handled is a function of which Baby Step one is currently on. During Baby Step 0 or Baby Step 1 there should be no sinking funds at all. During Baby Step 2 there should only be sinking funds for known expenses with a specific due date. (No, December 25th doesn't count; Christmas is a craft during Baby Step 2.) From Baby Step 3 and beyond, sinking funds for more non-specific expenses such as vehicle/home maintenance, vacations, and longer-term “wants” (and yes, Christmas) can be added.

Actually setting up a sinking fund can be as easy or difficult as desired. It also depends on how big of a Nerd the person setting it up is. There will be a happy medium somewhere between a number written in crayon on a piece of paper stuck to the refrigerator and 142 separate bank accounts tracked individually through YNAB. Where that happy medium lies will depend on the individual(s) involved.

Using for an example the author's setup – out of convenience and familiarity – one approach is to leave all funds combined in a single checking account and then use software (specifically Microsoft Money and a spreadsheet) to keep track of what money belongs where. Money tracks Checking and Sinking Funds as two separate accounts. Checking tracks all individual expenses and if something is paid out of a sinking fund there is a transfer from Sinking Funds to Checking for the amount in question. There is also a monthly transfer from Checking to Sinking Funds to do the funding for the sinking funds. All the specifics of what sinking fund is affected by what transaction in Money are located in the spreadsheet. The spreadsheet has a separate column for each individual sinking fund and a total at the bottom of each column. Each row holds a transaction marking money taken from or deposited to that sinking fund. Reconciliation involves matching the sum of the column totals from the spreadsheet to the balance in Money's Sinking Funds account and then subtracting that number from the bank's ending statement balance to arrive at the number Money's Checking account balance should reconcile to.

For sinking funds for specific expenses, it is often possible to know in advance how much is going to be due the next time. The sinking fund is then added to on a monthly basis with an amount equal to the total due divided by the number of months until it is due. Annual expenses should be funded monthly with one-twelfth of the total, semi-annual expenses with one-sixth, and so forth. When setting up the sinking fund for the first time there may be fewer months until the expense is due and a larger monthly amount will need to be allocated in order to have the full amount available when the expense is due.

When an expense is not precisely known it is often possible to use the previous amount of the expense and then estimate an increase. While this method may not yield the exact amount due once it becomes known, it should at least reduce the amount which needs to be added in that final month to a manageable number. Other more generic funds such as Repairs or Gifts are completely reliant on estimation to determine the amount of monthly funding. In those instances, it may also be desirable to establish a “cap” to the fund – an amount at which no further contribution to the fund would be necessary.

If you are new to Debt Free Fanatics, and want to learn more about techniques for getting out of debt, we encourage you to register and participate in our forums. Our members have been managing their money for years and are happy to offer advice and instruction on how you can manage your money better and get out of debt.